Hedge funds: Back to normal?

As quantitative easing unwinds in the U.S. and markets begin to normalize after five years of recovery, will hedge funds reassert the long-term risk-return profile investors have come to value and expect?

IN BRIEF

Hedge fund relative performance has been challenged during the recent five-year market recovery. Our analysis suggests, however, that hedge funds have continued to provide access to a differentiated return stream and, as the markets begin to normalize, are positioned for improved performance and upside capture over the short to medium term:

While hedge funds have underperformed conventional assets on an absolute basis over the last five years, they continue to provide alpha and portfolio diversification.

Long-term investors who focus on performance over an investment cycle have benefited from allocating to hedge funds.

Managers with more flexible investment toolboxes may benefit from recent structural changes in markets, such as the decline in market liquidity.

Historically, low growth, low inflation and rising rate environments have been attractive for hedge funds, while volatile markets have provided a relative advantage.

As quantitative easing unwinds in the U.S. and markets begin to normalize after five years of recovery, will hedge funds reassert the long-term risk-return profit investors have come to value and expect?

Based on a critical look at hedge fund performance over the last five years, a longer-term analysis across past market cycles and our forward-looking perspective on growth, inflation and interest rates, we believe the answer is YES. Hedge funds have continued to provide access to a differentiated return stream and appear positioned for improved relative performance and upside capture over the short to medium term.

Understanding the last five years

Hedge funds helped to mitigate the downside during the financial crisis, but, over the past five years have underperformed global equities and high yield bonds on an absolute basis and investment grade bonds on a risk-adjusted basis (Exhibits 1A and 1B). This is not surprising, given that conventional asset classes have been supported by unconventional monetary policy, which has taken a significant amount of risk out of the market. Because hedge funds do not run 100% net long, we expect them to underperform in strong stock and bond rallies.

Despite the absolute underperformance, hedge funds have continued to generate alpha and asymmetric up/down capture over the past five years. Risk-taking, or beta to the markets, is lower since the crisis, as is alpha, but hedge fund alpha is still positive and compelling versus other active investment strategies. Specifically, on an annualized, beta-adjusted basis, hedge funds (as measured by the HFRI Fund Weighted Composite Index [HFRI FWC]) have generated 140 basis points (bps) relative to the MSCI World Index and over 625 bps relative to the Barclays US Aggregate Bond Index (Barclays Agg) over the past five years.

On an up/down market capture basis, hedge funds (HFRI FWC) have captured 38% of the upside and 32% of the downside of the MSCI World Index over the past five years. Over the same period, they have captured 53% of the upside and -80% of the downside of the Barclays Agg (that is, hedge funds delivered positive returns, on average, when fixed income assets declined). However, solid manager due diligence and selection can vastly improve the experience.

Structural changes: supportive of hedge funds?

There have been structural changes to the underlying markets over the last five years—notably, reduced market liquidity. With all of these issues at play during stress periods, the question is whether hedge funds can overcome these structural headwinds.

Reduced liquidity

October 2014 was a reminder of the volatility that is likely to resurface in the markets. Liquidity remains a challenge, with the number of market makers having declined: J.P. Morgan Securities LLC reports that in the agency MBS market the top five dealers account for 78% of market share, compared with 60% in third-quarter 2004. Market makers are taking less risk, and financial regulation is discouraging repo activity for banks. If financing becomes more expensive or harder to obtain, leveraged investors’ appetite for risk will likely decrease.

Looking more closely at the government bond markets, supply has increased over the past 10 years, while dealer balance sheets have steadily declined (Exhibit 2). As evidenced by the extreme volatility in the U.S. government bond markets in October 2014, the absence of dealer inventory, along with reduced balance sheets and market-making capacity, has caused a systemic rise in interest rate and credit market volatility during periods of market stress (Exhibit 3).

There may be a long period of adjustment within the markets to compensate for this reduction in dealers and the role they played in smoothing out market volatility. Hedge fund managers, however, have better tools for maneuvering through these periods than do traditional money managers—including more flexible exposure management, more active trading styles and the ability to short.

Crowding

When many hedge funds have exposure to the same or similar positions, the position is said to be “crowded.” Crowding in hedge funds seems to get more attention when a sell-off occurs and the crowding negatively impacts returns. The September–October 2014 sell-off suggests there is some truth to this statement, given that more widely owned names under- performed names less frequently held by hedge funds (Exhibit 4). However, over longer periods of time, crowding has been a positive for hedge fund returns. Exhibit 5 shows that, since its inception, the Goldman Sachs VIP Index1 has added value vs. the S&P 500 and MSCI World indices.

Crowding can extend beyond equities into interest rates, foreign exchange and credit. In some distressed-debt situations, hedge funds are the primary investors. As an example, consider a hedge fund invested in the pre-exchange sovereign debt of Argentina2 along with a handful of other hedge funds. As with many event-driven positions, the outcome is somewhat binary. In this case, as long as Argentina pays the pre-exchange bondholders, the position should be profitable. Because ownership is dominated by hedge funds, temporary mark-to-market gains or losses can be driven by technicals. If one of the core holders experiences redemptions, it may be forced to sell its holdings to raise cash, which could push the price of the “holdout bonds” lower. In our view, these situations are best managed by dedicated credit hedge fund managers with stable asset bases who are willing to trade opportunistically to improve returns.

We believe it is important to monitor crowding at the portfolio level to ensure proper position and thematic diversification, and to protect against market shocks that specifically affect crowded names.

A longer-term perspective

In our view, the value of hedge funds is more accurately represented by analyzing performance across market cycles rather than over a five-year market recovery period. Over the past 20 years, or multiple market cycles, the HFRI FWC has outperformed the Barclays Agg on an absolute average annualized return basis and the MSCI World Index on both an absolute and a risk-adjusted basis (Exhibit 6).

In the two most recent periods of severe market stress—the global financial crisis and the dot-com crash—hedge funds provided more downside protection relative to other asset classes and vs. 60/40 and 45/55 combined stock/bond portfolios (Exhibits 7A and 7B).

More recently, in the two largest drawdowns in global equities over the past five years, hedge funds again demonstrated their ability to protect capital (Exhibits 8A and 8B).

Looking ahead

The question now is whether the current environment is conducive to hedge funds reverting to longer-term asymmetric return patterns and capturing more of the market’s upside and less of the downside. To answer that question, we analyze the current growth/inflationary trajectory and the impact of rising rates.

Performance across different growth and inflationary environments

The prospects of low corporate revenue growth, decreasing corporate earnings growth and low bond yields are all creating headwinds for traditional equity and fixed income investors. These headwinds are likely to remain in place for the near to medium term, amid moderate U.S. economic growth and a mixed picture for global growth.

To assess hedge fund performance in such an environment, we begin by studying how hedge funds performed in different growth and inflationary periods. Exhibit 9 shows historical average quarterly returns of hedge funds, investment grade bonds, equities and high yield bonds since 1990 in four different growth and inflation regimes, as represented by U.S. gross domestic product (GDP) and the consumer price index (CPI), respectively. Hedge funds outperformed all asset classes in all environments with just two exceptions: (1) equities outperformed hedge funds in periods of high growth and low inflation, and (2) aggregate bonds outperformed hedge funds in periods of low growth and low inflation.

Expectations for global economic growth and inflation remain low to moderate over the short to medium term (consistent with the upper left quadrant of Exhibit 9), which should make hedge funds an attractive complement to equities. Also, as we will see below, in today’s low interest rate environment, hedge funds can mitigate the risks from a rise in interest rates.

The march toward rising rates

As unconventional monetary policy begins to unwind and the economic recovery persists, conventional assets should become riskier. Hedge funds have historically performed well in periods of rising equity volatility (as measured by the CBOE Volatility Index [VIX]) and rising rates. This phenomenon holds true for periods before and after the global financial crisis.

When the VIX rose from 19 in July 2001 to roughly 32 in September 2001, hedge funds protected capital better than other asset classes. Similarly, hedge funds outperformed other asset classes when the VIX rose from just below 11.5 in June 2014 to 16.3 in September 2014 (Exhibits 10A and 10B).

Hedge funds have also performed quite well when U.S. government bonds have declined—delivering positive average returns across down months over the past 15 years (Exhibit 11). For example, when rates rose from 4.6% in January 1999 to 6.3% in May 2000, hedge funds (HFRI FWC) generated a 34.8% return vs. 17.8% for global equities (MSCI World Index), 1.03% for investment grade bonds (Barclays Agg) and 0.17% for high yield bonds (JPMorgan High Yield Index). For investors in search of yield and credit exposure, hedge funds can potentially offer both—with less interest rate and duration risk.

Complementing equity allocations with equity hedge funds

Over the long term, equity hedge funds have been able to deliver strong risk-adjusted returns compared with the principal equity market indices. Since 1990, the HFRI Equity Hedge Index has generated returns of 12.6% with 9.0% volatility vs. the MSCI World Index’s 5.9% return with 14.3% volatility and the S&P 500’s 9.5% return with 14.8% volatility. Especially noteworthy given current market conditions, the majority of these hedge fund returns consist of alpha: Equity hedge funds generated annualized alpha of 7.8% vs. the MSCI World Index and 6.2% vs. the S&P 500.

Equity hedge funds have also been able to preserve capital in down markets, a paramount consideration for investors looking to reduce equity volatility without sacrificing return potential. Outside of the unprecedented financial system stress of 2008–09, equity hedge funds have done a good job of avoiding large drawdowns, which has enabled them to compound returns Equity long-short hedge fund drawdowns have been milder than the broader market’s more quickly than their benchmarks. Exhibit 12 shows every equity market drawdown greater than 2% since 1990 (for the MSCI World Index) and the performance of equity long-short hedge funds during each drawdown.

All told, equity long-short hedge funds have generated approximately 71% of the MSCI World Index’s returns with only 25% of its losses (Exhibit 13).

With the economy showing moderate signs of improvement, we could begin to see greater dispersion in share performance, which would also bode well for stock pickers. In a recovering economy, corporations invest in their own operations and feel more confident in distributing cash to shareholders. The higher interest rates that often accompany an expansion could increase

Equity long-short hedge funds’ consistent performance through rallies and retreats has led to greater long-term appreciation dispersion still further. More capital-efficient companies should benefit as poorly run competitors struggle to cope with greater interest expenses. In a recovering economic environment, stock-specific dynamics would give equity hedge funds more opportunities to generate attractive returns on an absolute and a relative basis.

Portfolio management

Looking ahead to a more conducive environment for hedge fund performance, but one with structural challenges and higher volatility, hedge fund investors will have to focus, perhaps more than ever, on three key areas: selecting the right managers, thorough risk management and tactical asset allocation.

Manager selection

The hedge fund universe has grown rapidly over the past decade, despite pausing briefly during the financial crisis. According to Hedge Fund Research (HFR) assets are approaching US$3 trillion and the number of hedge funds has grown to over 9,000—intensifying the due diligence challenge for investors.

The past decade has also seen a large dispersion in hedge fund returns within different strategy types—a far greater dispersion than for long-only strategies (Exhibit 14). For example, over the 10 years ending December 2013, per annum returns for top quartile equity long-short hedge funds exceeded median returns for these funds by 2.7% to 10.2%. In contrast, top quartile long-only funds outperformed their median by only

Greater dispersion of returns highlights the importance of hedge fund manager selection 0.7% to 2.3%. More recently (October 2009–September 2014), 95% of funds within the HFRI FWC had annualized returns between -5.6% and +24.6%, emphasizing the importance of manager selection.

Risk management

Following periods of sustained positive market directionality, hedge fund managers have historically increased their beta exposure (Exhibit 15). The temptation to add beta in order to decrease tracking error vs. overall market returns is strong, especially among strategies with the leeway to do so (event-driven, equity long-short, macro). This effect extends even to those managers who view market returns as irrelevant, but are still concerned with their tracking error vs. peers. Even among managers who don’t feel the need to increase beta to keep up, the low volatility that follows periods of strong market returns often lulls managers into a false sense of security, making the opportunity cost of running loosely hedged portfolios low.

Hedge funds that adhere to strict discipline around market exposures can ensure their returns are alpha-driven.

To counter these pressures, hedge funds that adhere to strict discipline around market exposures can ensure their returns are alpha-driven. Discipline around market exposures requires the ability to measure them, even in an environment of changing correlations. For example, the correlation between equities and rates has become highly unstable, moving from very negative (making long sovereign debt an effective hedge for long equity risk) to positive and back again. We saw this instability in the U.S. during the taper scare of second-quarter 2013 and in Europe, where peripheral sovereign debt has moved from being a risk-on asset to a risk-off asset in the span of a few years.

Understanding how risk management has evolved and the extent to which managers have integrated these advances into their own investment processes remains a critical component of manager due diligence. For example, changing correlations should now be monitored more closely, using higher frequency data. Managers also have more ways to respond to change, using market innovations such as high yield and loan exchange-traded funds (ETFs) and sovereign credit default swaps (CDS). These developments help to ensure that portfolios are sufficiently protected, with hedges that are not highly dependent on unstable correlations.

Tactical asset allocation

Though hedge fund returns have been attractive over the long term, investors can further enhance their returns with timely strategy allocation shifts. Similar to equities and bonds, the relative attractiveness of hedge fund strategies will change materially depending on factors such as the macro environment, valuations, market liquidity and available deal flow. This variability can translate into frequent changes in relative returns among hedge funds. Exhibit 16 shows the returns of the various hedge fund strategies and broad markets each year since 2001, ranked from the highest returning strategies to the lowest. As shown, the strategies that outperform and underperform change considerably from year to year. Investors (or their advisors) with a defined process and the capital markets expertise to prudently adjust strategy allocations can outperform a passive hedge fund index that maintains a relatively constant strategy composition.

Taking into account current market views, for example, we see event-driven (including activism), process-driven credit and low beta/relative-value-oriented equity and credit strategies as providing attractive investment opportunities over the near to medium term. These strategies are less reliant on organic earnings growth to drive shareholder value. For example: Event-driven managers often target merger and acquisition opportunities to drive growth; process-driven credit managers can be involved in litigation or bankruptcy situations, which have outcomes driven by a legal process; and lower beta/ relative-value-oriented equity and credit managers may unlock arbitrages within a company’s capital structure, isolating inefficiencies in a market.

Conclusion

Unconventional monetary policy has fueled a five-year rally in risk assets. Looking ahead, we believe that returns from traditional asset classes will likely be more muted and that volatility will rise. Navigating the quantitative easing unwind will require investors to assess how their portfolios will react to such a significant policy change. We believe that hedge funds are positioned to outperform in such a market, as a result of both their more flexible investment universe and their ability to construct well-diversified portfolios of lowly correlated assets. Investors must keep an eye on risk within their portfolios and actively (re)position portfolios for this new regime.

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The Goldman Sachs Very Important Position Index tracks the performance of the 50 stocks that appear most frequently in the top 10 holdings of fundamentally focused hedge funds.

Several hedge funds own Argentinean sovereign bonds that were not exchanged when the country defaulted in 2001. The bonds were issued under New York law, so the legal battle has played out in U.S. courts. Argentina has been steadfast in its stance that it should not have to pay the hedge funds, but the legal decision concluded in June. The so-called “holdout bonds” benefited when the United States Supreme Court declined to hear Argentina’s appeal of the pari passu injunction. The ruling prohibits Argentina from paying any bond holders without also making payment on the holdout bonds.

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